ANALELE TIINIFICE ALE UNIVERSITII ALEXANDRU IOAN CUZA DIN IAI

Tomul LV tiine Economice 2008

THEORIES REGARDING THE BANKING ACTIVITY
Alin Marius ANDRIE
*

Abstract
The banking activity is varied and complex and thus it is difficult to define banks. The literature
on the field several theories that try to explain the existence of banks in economy were developed.
These theories start from certain concepts such as: monitoring commissioning, information
processing, liquidity transformation, smoothing of consumption and commitment method.
Understanding the role banks have in the financial systems is one of the fundamental themes in eco-
nomic and financial theory. The efficiency of the process through which economies are channeled into
productive activities is crucial for the economic growth and well being. Banks are a part of this
process of transfer of the funds from surplus agents towards deficit agents.

Key words: banking theory, functions of banks, banking crisis
JEL classification: G21, O44,
Introduction
The banking activity is varied and complex and thus it is difficult to define banks.
From an operational point of view banks are institutions whose current operations consist
in granting loans and attracting deposits from the large public [Freixas, Rochet, 2008, 1].
It is important to notice that granting loans and attracting deposits constitutes the
current operations of the banks, because other commercial companies also occasionally
grant credits to their clients or borrow from suppliers. Banks finance a large part of the
granted credits by attracting deposits from the population and offer an array of services of
public interest. The guaranteeing of the deposits of the population and the organizing of an
efficient and safe payment system justifies a more careful regulation of this field.
1. Theories regarding the existence of banks
The literature on the field several theories that try to explain the existence of banks in
economy were developed. These theories start from certain concepts such as: monitoring
commissioning, information processing, liquidity transformation, linearization (smoothing)
of consumption and commitment method.


*
Alin Andrie (andries.alin@yahoo.com)) is PhD student of Business Administration Department, Faculty of
Economics and Business Administration, Al. I. Cuza University, Iasi-Romania. His research interests include:
financial intermediation, banking and financial banking.
20 Alin Marius ANDRIE
1.1. Delegated monitoring
One of the most well known theories that try to explain the existence of banks and of
the banking activity refers to the role of banks as an entity that follows and verifies
debtors. Because the monitoring of the credit risk determined by the debtors inability or bad
faith is costly, it is more efficient for the commissioning units (depositors) to delegate this
monitoring activity to some specialized entities such as banks. Banks have the necessary
expertise and they also benefit from the large scale economy in the processing of
information regarding debtor risk.
One of the most relevant studies that explains why monitoring commissioning is the
reason for the existence of banks is Financial intermediation and delegated monitoring
written by D. W. Diamond. He analyses the determining factors for the commissioning of
monitoring and developed a theoretical model in which the financial intermediaries,
especially banks and insurance companies, have a net comparative advantage from the point
of view of costs in relation to direct financing. The theory developed by Diamond is based
on 2 premises[Diamond,1984]:
a) diversity of the investment projects, that explains why it is more advantageous to delegate
monitoring towards an intermediary than to have it be performed individually by creditors;
b) intermediaries who perform the monitoring of debtors are bigger which allows them to
finance a large number of debtors.
Considering the fact that diversification leads to the increase of the number of bank
credits, the financial intermediaries of larger sizes will generate important scale economies
in the monitoring process, which allows them to diversify the investment portfolio better
than any individual creditor.
1.2. Process of information
The obtaining of information regarding the investment opportunities is not free of
charge which determined the specialization of some agents in the obtainment and
manufacturing of such information. In the resource allocation process the surplus agents
would register substantial costs if they were to find the potential partners on their own. The
inexistence of banks would lead to the multiplying of the information manufacturing costs
because each surplus agent would spend considerable amounts in search of the relevant
information before setting their own funds at the disposal of the deficit agents. An alternati-
ve consists of the existence of a lower number of agents specialized in the manufacturing of
information necessary for the investment process.
Banks have the necessary expertise in the processing of information regarding deficit
agents, information they obtain because of the experience earned in time in the relationships
with deficit agents. Banks have the necessary know-how for performing this type of
activities which makes them very attractive for the fund owners. They will want to invest
the available funds through banks knowing that they will allocate the funds to debtors who
will have the ability to reimburse the loan and, thus, avoid the registering of some costs with
obtaining information.
1.3. Liquidity transformation
Banks set at the disposal of surplus agents (deponents) primary or secondary asset-
backed securities with a superior liquidity. The bank deposits can be seen as credit
agreements that present a high liquidity and a low risk and which are founded on the
Theories regarding the banking activity 21
resources attracted by the bank. Banks achieve a transformation of the size of the assets in
the sense that they establish the size of the assets depending on the needs of the client,
attract small size deposits and grant high value credits. Thus the banks based on the attracted
small size deposits grant much larger credits, this transformation can occur because of the
access banks have to a large mass of deponents and of the scale economy. Thus banks create
liquidity that individual surplus agents can not.
Banks transform the deposits made mostly for short term into medium and long term
credits. This non-correlation between the due dates of attracted deposits and the due dates of
the granted credits can lead to the emergence at the level of the banks of the liquidity risk;
but the larger the banks portfolio of assets and liabilities the lower the risk for breach of
obligations.
1.4. Smoothing of consumption
Recent studies [Bhattacharya, Thakor, 1993, 2-50] show that banks play an important
role in the linearization of consumption, in the sense that banks are institutions that facilitate
the linearization of the consumption of economic agents through insurance against liquidity
shocks. The banking institutions can be seen as a liquidity source that insures the physical
and artificial persons against particular shock that can affect their consumption needs
[Freixas, Rochet, 2008, 20]. This theory is founded on the hypothesis that the economic
agents have uncertain preferences regarding the expenses that determine a consistent
demand for assets with a high liquidity. The financial intermediaries in general, banks
especially, offer such assets by attracting depositors and granting credits and this facilitates
the linearization of the individual consumption.
1.5. Commitment method
In the scientific process of explaining the existence of banks some authors [Casu,
Girardone, Molyneux, 2006, 16] try to justify why bank assets (credits), which in principle
are not liquid, are financed through bank deposits, most times on sight, deposits which allow
deponents to liquidate at any time the performed deposit. These authors claim that the sight
bank deposits have developed as a disciplining instrument for bankers. The sight deposits
developed in order to limit the predilection of banks towards risk, thus the changes in the
offer and demand of this type of bonds will reflect into the financing costs and will oblige
banks to adopt a prudential behavior, ensuring that they have enough liquidities and capital
resources.
2. Functions of the banks
The main functions of the banks are to collect funds, especially in the shape of
deposits, from the surplus agents and to lend funds in the shape of credits to deficit agents.
The attracted deposits, as financial assets, present certain characteristics: low size as volu-
me, low associated risk and a high degree of liquidity. The granted credits present
characteristics diametrically opposed to deposits having a high associated risk, being of lar-
ge sizes and with a low degree of liquidity.
The contemporary bank theory classified the functions of the banking activity into 4
categories [Casu, Girardone, Molyneux, 2006, 2]: offering of transfer and payment services;
22 Alin Marius ANDRIE
transformation of assets; risk management; processing of information and monitoring of
clients.
In a world with no transaction costs there would be no need for money, but considering
the differences that occur in the real economy it is more efficient to exchange assets and
services for money that for other assets and services, like in a barter based economy. The
form of manifestation of money has evolved from the merchandise currency to the scriptural
currency [Turliuc, Cocri, 2007, 23-33]. Banks have a double role in the commerce with
fiduciary money, money whose value is recognized and guaranteed by an institution: it
performs the exchange between different currencies issued by different authorities and
insures a payment system that enables the management of the client accounts and the
performing of transfers between the accounts of different clients. The banks insure the trans-
fer of important amounts of money over large distances under safe conditions, in short time
and at reasonable costs. The safety and efficiency of the payment systems has become a
priority of the monetary authorities and of the central banks especially during the past
decades since on the international markets there was manifested a phenomenon of
deregulation and globalization of the financial markets, concomitantly with a significant
increase of the volumes transferred through the national or international payment systems
administered by private entities [Rochet,Tirole, 1996].
In order to satisfy the needs of the deficit agents based on the amounts attracted from
the surplus agents the banks have to perform a modification of assets. The modification of
assets can be analyzed from several perspectives: transformation of the size of the assets,
qualitative transformation and the transformation of due dates.
Banks perform a transformation of the size of the assets in the sense that they establish
the size of the assets based on the needs of the client, attract small size deposits and grant
high value credits. Thus based on the small size deposits attracted, banks grant much larger
credits, this transformation can occur because of the access banks have to a large mass of
deponents and the scale economy.
All credits have a non-reimbursement risk associated to them, called credit risk, which
consists of the possibility that the debtor does not have the ability to reimburse the
contracted credit. Banks have the possibility to minimize the individual credit risk by
diversifying the investment portfolio, covering risks, evaluating and monitoring debtors.
Banks transform the deposits made mostly for short term in medium and long term
credits. This non-correlation between the due dates of the attracted deposits and the due
dates of the grated credits can lead to the emergence at the level of the banks of the liquidity
risk.
Risk management, in broad sense, constitutes the main activity of the banks [Freixas,
Rochet, 2008, 221]. Banks, in general, must select and control the risk inherent to the mana-
gement activity of deposits, credit portfolio and, lately with an increasing weight in the
banking activity, extra balance-sheet operations. Considering that the bankruptcy of a
banking institution can have a negative effect on the financial system as a whole, the
regulation and supervision organisms of the baking system must carefully monitor the
balance and extra balance-sheet operations of the banks. The risks specific for the banking
activities are [Heffernan, 2005, 104]: credit risk, market risk that comprises foreign currency
risk and the interest rate risk, liquidity risk, operational risk and systemic risk. Banks have
developed over time risk management systems through which they can limit or cover the
risk they are exposed to.
Theories regarding the banking activity 23
Banks have an important role in the management of problems caused by information
asymmetry in the relationship with debtors. Banks invest in technologies that allow them to
evaluate the potential beneficiaries of the credits and to monitor their projects. The
monitoring activity implies the development of a long term relationship between companies
and financial intermediaries so as to eliminate the effects of the moral hazard [Mayer, 1988].
The monitoring activity performed by banks constitutes one of the major differences
between the crediting activity performed by the banks and the issuing of bonds on the
financial markets. Thus if the price of the bonds reflects the information on the market, the
value of the bank credits results from the long term relationship between the bank and the
client and it is a priori unknown for all parties involved [Freixas, Rochet, 2008, 6]. Thus it
can be said that bank credits are opaque [Merton, 1995].
Banks reduce the transaction, research and information costs especially because of the
scale economy, by increasing the transacted volumes, the transaction cost per unit decreases.
Savings also come from the advantages financial intermediaries obtain from their
specialization. Thus, when an intermediary specializes in a certain type of activity or in an
activity sector, this situation allows it to offer services less costly and adapted to the needs
of the clients. At the same time, the registering of some important savings also results from
the diversified array of services offered to clients. This is the reason why banks seek to
diversify their offer of products, so as to optimize infrastructure costs.
All contracts and transactions are based on information [Casu, Girardone, Molyneux,
2006, 9], in financial intermediation certain problems can occur: not all participants have the
same information; all participants are not perfectly informed; part of the transaction can hold
inside information, which is not available to both parties.
The information asymmetry (or informational asymmetry) can generate problems
regarding the adverse selection and the moral hazard which can make the signing of
financial agreements difficult decreasing the interest of participants and leading to the
inefficiency of the financial intermediation.
Banks allow for the decrease of information asymmetries and contribute for a better
allocation of the resources in economy. This function of the banks comes from the fact that
their intermediation function gives then an informational advantage in relation to direct
financing. Banks can hold private information, which is not circulated on the financial
market. For example, if a client requires a financing application, then its bank has the
possibility to evaluate the client, because it is administering their accounts and can obtain
important information regarding the turnover, profitableness and indebtness degree.
Through such a knowing of its client, the bank prevents the dissimulation of information
before the signing of the agreement and reduces, thus, the information asymmetry, which
leads to the adverse selection (representing a situation independent from the action of the
contracting parties). For example, on the credit market, the banker ignores the exact
characteristics of the investment project the enterprise intends to finance. Also, the financial
intermediary guarantees the confidentiality of information, which can constitute a decisive
advantage for creditors. Because of this characteristic the financial intermediaries have an
advantage in comparison to the financing made on the market.
Secondly, any loan requires the achieving of the execution of the agreement, because
after signing it the risk of a partial execution or of the non-execution of the control can be
manifested. Such a form of asymmetry manifested subsequently, leads to the idea of
morality, in the sense that the intermediaries can decrease the supervision costs and can
24 Alin Marius ANDRIE
establish statistic or accounting methods by using specialist services. The latter exercise in
turn an elaborate monitoring of the agreements and thus decrease the bankruptcy risk.
Banks have a well determined role in the decrease of information asymmetry, because
they maintain long term relationships with their clients through the very nature of the
fulfilled functions.
3. The role of banks in financial systems
Understanding the role banks have in the financial systems is one of the fundamental
themes in economic and financial theory. The efficiency of the process through which
economies are channeled into productive activities is crucial for the economic growth and
well being. Banks are a part of this process of transfer of the funds from surplus agents
towards deficit agents.
Even though in the past years on a global level the phenomenon of globalization that
leads to the levelling of the financial systems was manifested, the role of banks in different
economies still differs significantly. One method to see the importance of the banking
system in an economy is to analyze the way deficit agents finance their long term
investments.

Source: [Allen, Carletti, 2008, 29]
Fig. 1. Size of financial markets in developed countries/regions
In the figure above there can be seen that in certain states/regions, such as the Euro-
pean Union, the banking system insures the greatest part of the resources necessary for long
term financing and these states are considered to have a financial system based on banks, in
other states there is shown that the greatest portion of resources are attracted with the help of
capital markets, like in the USA, these states having a financial system based on markets
and there are states that have a financial system in which banks and capital markets ensure a
comparable amount of funds for long term investments (Japan and Great Britain).
Another method to analyze the role of banks in economy is to analyze the way in
which surplus agents invest their economies.
Theories regarding the banking activity 25

Source: [Allen, Chui, Maddaloni,2004, 493]
Fig. 2. Portfolio of assets of surplus agents (average for the period 1995-2002)
It is seen that in Europe and Japan the physical persons have most of their economies
in the form of deposits or other bank assets, while in the USA and in Great Britain physical
persons place their economies into shares, pension funds and insurance companies.
3.1. The role of banks in the monitoring of debtors
An argument used frequently by specialists who claim that the financial systems based
on banks are more efficient is the fact that banks allow for the solving of many problems
concerning informational asymmetry. An important problem that occurs in the fund transfer
process from surplus agents to deficit agents is if debtors have to take all the measures so
that the loaned funds are used in the most effective way. These measures can consist of the
depositing of all diligences or in the choice of the most profitable alternatives. Creditors can
not notice the behavior of debtors unless they monitor the debtor, but since most times they
do not have the ability to personally perform this activity they must pay an amount of
money to a third party that monitors the debtor for them. In a financial market with many
creditors there emerges the so-called problem of the clandestine passenger (free-rider).
Because creditors have limited resources it is not to their advantage to pay for the
monitoring costs and thus all creditors would like that the other creditors pay for these costs
and they adopt a behavior of clandestine passenger. If all creditors adopt this behavior no
one will perform the monitoring of debtors any longer.
One possible solution would be the hiring by all creditors of a third party that performs
this activity, the so called commissioning of monitoring, but this solution also gives birth to
another problem: who monitors the third party that monitors the debtors? Diamond has
developed a model regarding the commissioned monitoring in which he shows that banks
have the interest to act as a third party who performs the monitoring of debtors and produces
the information necessary for an efficient allocation of resources [Diamond, 1994]
In the literature in the field [Boot, Thakor, 1997] there was even developed a model for
the architecture of the financial system starting from this concept: banks entities that
perform the monitoring activity of debtors in the name of creditors, and having as premise
the existence of 3 types of informational problems: a) the existence of incomplete
26 Alin Marius ANDRIE
information regarding the future projects of the company; b) creditors dont know if the
debtors place the funds into safe or risky investments; c) the probability that debtors have
the opportunity to invest into risky projects. The 2 researchers show that the first
informational problem can be solved by the financial markets and the second and third
problems can be solved by financial intermediaries. These results demonstrate that the banks
will dominate in an emerging financial system while the informational advantage of the
financial markets allows them to be more developed in the mature financial systems.
3.2. The role of banks in risk management
One of the most important functions of the financial system is the decreasing of risk by
diversifying the investment portfolio. The followers of the financial systems based on
markets claim that this type of financial systems performs the function of risk management
better than the financial systems based on banks because they can perform the
diversification of the portfolio much better and allow individual investors to diversify the
portfolio. The diversification of the portfolio does not lead to the elimination of risk, but to
its redistribution among several investors, thus the ones who have an adversity to risk will
be exposed to some lower risks, and the ones with a bigger tolerance to risk will be exposed
to higher risks.
The followers of the financial systems based on banks claim that the financial systems
based on markets perform a better management through the corresponding diversification of
the portfolio only of the unsystematic risk (risk caused by frauds or management mistakes,
wrong strategic approaches of the market, decrease of the demand or of production, etc), but
they can not also perform a management of the systematic risk which affects all the assets in
the same way.
The followers of the financial systems based on banks claim that the banks have the
ability to also cover the systematic risk through the intertemporal linearization of risk. Some
researchers [Allen, Gale, 1997] have shown that although the systematic risk can not be
eliminated through the diversification of the portfolio at a given time, it can be balanced in
time so as to reduce its impact on the individual well being through intertemporal
linearization between banks. This implies that the banks accumulate certain reserves when
the profitableness of the assets is high that they use when the profitableness is low. The
banks can perform the intertemporal linearization of the risk through the payment of a
relatively constant periodical interest and thus deponents are not exposed to systemic risk.
Banks achieve this linearization of risk in the financial systems with a lower
competition easier, because a very high level of the competition leads to disintermediation
and thus this intertemporal linearization of risk can no longer occur.
3.3. The role of banks in the durable economic growth
Another important role of the banks is the facilitation of economic growth. In the
literature in the field an entire theory regarding which type of financial systems best
promotes the economic growth was developed. Some recent studies [Levine, 2002] have
shown that the structure of the financial system has no importance in the promotion of eco-
nomic growth but the legal frame and the quality of the financial services matter more,
while other studies [Tadessee, 2002] claim that the structure of the financial system does
matter in the performing of a durable economic growth. Thus for the developing countries
the financial systems based on banks are more efficient than the financial systems based on
Theories regarding the banking activity 27
markets in the promoting of economic growth, and in the developed countries the financial
systems based on markets are more efficient than the financial systems based on banks.
Some studies [Levine, R., Zervos, 1998] show that the existence of some financial
markets with a high liquidity or of a developed banking system facilitates the economic
growth no mater the development level of the other component and that financial markets
and banks are complementary in supporting economic growth.
Instead of conclusions Banks and financial crises
The development of financial innovations and of risky speculations, the expansion of
credits, the increase of the price of assets with no economic basis, the sudden and
unexpected drop of the prices of financial assets and the quick orientation towards liquidities
or quality investments are inevitable as long as investors target to obtain the best profits.
Under these circumstances, the emergence of financial crises is nothing new, but, as a
defining trait of it, the global financial environment enables the possibility of transmitting
crises in the entire system, their contagion respectively.
Financial crises are characterized by an accentuated decrease of the price of assets, the
bankruptcy of some large financial and non-financial institutions, disfunctionalities on the
foreign currency markets. The factors that can determine the emergence of such a financial
crisis can be [Mishkin, 2001]: 1) deterioration of the balance sheet statement of financial
institutions, 2) increase of the interest rate, 3) increase of uncertainty in economy, and 4)
deterioration of the balance sheet statement of non-financial institutions because of the
volatility of the prices of assets.
Banks play a decisive role in the development of financial crises as financial
intermediaries that contribute to the efficient transfer of funds from surplus agents towards
deficit agents. Banks can facilitate financial crises through the activities deployed on the
financial markets which can influence the interest rates, the uncertainty on the market and
the price of assets, but more so banking crises that are transformed into financial crises can
occur. The banking crises can be defined as being a sufficiently difficult financial period
that leads to the erosion of most of or of the entire capital in the banking system [ Allen, Ga-
le, 2007, 3].
Studies [Allen, Gale, 2001] have shown that the emergence of crises is not conditioned
by the structure of financial systems, crises can occur in any type of financial system. The
emergence of banking crises depends more on the level of development of the financial
system or of the economy. The studies performed [Kaminsky, Reinhart, 1999] have shown
that most times the banking crises were preceded by an excessive exposure of banks on the
stock and real estate market. The emergence of banking crises is facilitated by the financial
liberalization process corroborated with an inefficient legislative system and with a high
degree of corruption [Demirgc-Kunt, Detragiache, 1998].
The contagion models were developed more recently, after the Asian crisis in 97,
which proved, more visible than in the previous cases, that when a country goes through a
financial crisis, at the same time and, especially, in the same area, other countries are
affected. In the past decades there was proven that a small amplitude shock can have a
significant impact on the financial markets. A shock that initially affects just a certain region
or a certain sector or even just certain financial institutions can be propagated, by contagion,
through the connections between banks and other financial institution towards the entire
financial sector or towards other regions.
28 Alin Marius ANDRIE
The analysis of the contagion effect can be made based on the direct connections
between banks, researchers [Allen, Gale, 2001] studying how the banking system reacts to a
crisis when the banks are integrated into a certain network. In a banking system in which
clients have a certain preference for liquidity, banks insure themselves against liquidity
shocks with the help of credits on the interbank market. The relationship developed between
banks through swap agreements exposes the entire system in case a liquidity shock occurs at
the level of one participant. Poorly developed baking systems are much more exposed to the
contagion effects than developed systems because in these developed systems the
relationships between banks are more developed and thus a larger portion of the portfolio
losses suffered by a bank is transferred to several banks through interbank agreements.
A theme of interest is represented by the analysis of the impact of the individual risk of
one bank on the entire banking system. Some authors [Freixas, Parigi, Rochet, 2000]
analyzed the case when a bank must face a liquidity shock and the connection between the
banking institutions is made through interbank credit lines. The impact of such a shock
depends on the ability of the system to face a regional liquidity shock. Other authors [Allen,
Gale, 2001] analyzed the impact of the bankruptcy of a bank on the entire banking system
and have shown that the more developed the interbank connections, the lower the impact of
a bankruptcy on the entire system.
In the analysis of the role of banks in the contagion of financial crises the financial
innovations and the accounting system used must also be considered [Allen, Carletti, 2006].
Surely the theories regarding banking crises and financial crises will know great
developments because of the global financial crisis which began in 2007.
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